Fed’s Bank Stress Tests Make Dubious Assumptions

March 13 (Bloomberg) -- The results of the Federal
Reserve’s 2013 stress tests are promising, showing that 17 of
the 18 largest U.S.-bank holding companies have a resilient base
of capital and could withstand three different severe recession
scenarios.

Performing well on these tests is highly important to banks
and shareholders, because the results will determine whether
certain banks may finally return capital to their shareholders.
Observers should keep in mind, however, that these stress tests
rely on three assumptions that are inconsistent with our
experiences during the past financial crisis and limit the real-world relevance of the tests.

First, the tests, based on any of the financial-shock
scenarios, assume that the short-term creditors of the largest
banks wouldn’t start a run on them. The importance of this
assumption is hard to overstate.

According to the Office of Financial Research, the
department established by the Dodd-Frank Act within the Treasury
to monitor financial stability, this assumption seriously limits
the value of these tests for evaluating that stability. It seems
entirely plausible that the shock scenarios imposed by the
stress tests, which include equity prices falling by 50 percent
and the unemployment rate rising to 12 percent, would result in
a large bank’s short-term creditors pulling their financing.

Stability Shaken

After the failure of Lehman Brothers Holdings Inc., it was
a run by these very creditors that necessitated intervention by
the Fed and the Treasury with unprecedented guarantees and
buying programs to support the money markets. The stability of
the entire financial system was truly at risk when the largest
banks stopped lending to one another and sophisticated
institutional investors ran on the prime money-market funds that
fund these banks.

If this were to occur again, the government would have to
intervene or banks would be forced to sell assets at fire-sale
prices, almost certainly rendering such banks insolvent.

Second, the stress tests assume that the shock scenario
wouldn’t result in banks reducing the credit they make
available. In reality, when a bank’s assets are severely reduced
in value, that is precisely what it does. The attendant
reduction in credit availability magnifies the severity of the
shock scenario, creating a vicious cycle. As seen during the
crisis, a reduction in large banks’ willingness to lend to other
large banks is particularly relevant to financial stability.

Although the Fed’s scenario includes other questionable
assumptions, including that banks would continue to pay
dividends during a severe recession, a more important point is
that the value of troubled assets is not knowable during a
crisis.

When trying to value troubled assets, to paraphrase former
Defense Secretary Donald Rumsfeld, we’re exclusively dealing
with “known unknowns” and “unknown unknowns.” This is precisely
why the original stated purpose of the Troubled Asset Relief
Program -- to clean up the balance sheets of troubled banks by
buying up toxic assets -- couldn’t have been carried out without
undue risk to taxpayers.

At the time, there was no way of knowing the actual value
of the relevant subprime-mortgage-backed securities and
collateralized-debt obligations, and this uncertainty helped
drive the general panic that seized up global financial markets.
The Federal Reserve stress tests have no way of accounting for
this uncertainty.

Thus, although the Dodd-Frank-mandated tests provide an
important window into the resiliency of our largest banks, they
do not mean that our banks could survive the severe-recession
scenarios imposed by the tests.

The Federal Reserve should work toward minimizing the
assumptions inherent in the stress tests. By requiring banks to
pass these tests in order to redistribute capital to their
shareholders, the Fed sends the message that these tests are
more relevant to financial stability than they really are.

(John Gulliver has worked for ACA Compliance Group, a
regulatory consulting company, and as a research associate for
the Massachusetts Institute of Technology Laboratory for
Financial Engineering. The opinions expressed are his own.)